Venture Capital

Bubble Indemnity

When Silicon Valley venture capitalists get themselves into image trouble, it’s usually because they’ve been too candid with their low estimate of other people’s intelligence. For example, after India recently prevented Facebook from offering free Internet service there, Marc Andreessen suggested in a tweet that the subcontinent might be better off had it remained under colonial administration. It’s much less common for V.C.s to soil their own nests in public. So it came as something of a surprise when Chamath Palihapitiya — Sri Lankan war refugee, early Facebook employee, investor in Slack and Box, part owner of the Golden State Warriors — told Vanity Fair in March that if we are in fact in the early stages of a second tech collapse, venture capitalists have only their own mediocre, clubby selves to blame. They should, he said, “focus on using capital as a way to take really big bets on things that just seem totally audacious. Right now we haven’t done enough of that, and the result is that most of the things we’ve funded are mostly crap and largely worthless.”

It was a striking admission. This “largely worthless” start-up scene, according to the research firm CB Insights, has raised an estimated $238 billion over the last five years — a remarkable bull run in private technology stocks. Forbes reports that there are now close to 200 “unicorns,” to use the Valley term of art for private companies worth more than a billion dollars on paper. Since the financial crisis, these companies, along with their more established public predecessors, have been seen by many Americans as the last redoubt of confidence and productivity in an otherwise uneven recovery. V.C.s have spent years dismissing speculation about a private-equity bubble as merely an expression, by know-nothing spectators, of resentment and alarmism; media onlookers, they argue, should talk instead about the triumphal progress of the genuinely great start-ups as they try to solve our most difficult problems. Over the past year, however, as allegations of mismanagement and unsustainability have grown — Square went public for approximately half its last private valuation; Fidelity and other large mutual funds wrote down their positions in Dropbox, MongoDB, and Snapchat; and both Zenefits and Theranos were accused of deceptive practices — that confidence has come to look more like hubris.

Venture capital increasingly represents a closed system — a system where it is no longer so easy to distinguish good money from bad.

This past January, after a long autumn of minor misfortune left the market in a stall, I spent a week loitering in the command concourse of American V.C., Sand Hill Road in Menlo Park, Calif., where the soft, spruce-filtered sunlight falls through plate glass into quiet offices of beige on beige. There was some selection bias at work, as all my introductions were brokered by a smart and thoughtful friend, but not a single investor I talked to fit the description of the supercilious techno-optimist — and most, in private, didn’t hesitate to concede Palihapitiya’s point. Of course they believed private valuations had become preposterous; of course the run in private tech stocks couldn’t possibly last; and of course, many start-ups, especially those of the “Uber for garden-gnome rearrangement” variety, are in fact largely worthless.

Where they differed from the naysayers, however, was in their rating of the ­causes­ and consequences; the fault, they said, didn’t belong to the technological elite but to everybody else: What has driven inflated valuations, in a time of extremely low interest rates and meager returns elsewhere, is “dumb money,” all the alien capital that has flowed into the Valley in recent years. Dumb money is a hedge-funder who’s jealous of a V.C. Dumb money is sovereign wealth. Dumb money is an Emirati home office. Dumb money is a Facebook millionaire in a Maserati who wants to look like a player. Dumb money wants to get in on tech because it’s a box to check off. Dumb money isn’t in it for the long run. Dumb money doesn’t actually care about the technology. Dumb money doesn’t create value. Dumb money thinks what you lose on the margin you’ll make up for in volume. Dumb money wants to get in on Uber at any price, and will accept a “limited-edition private offer” to join the scarce ranks in a “special purpose vehicle” that bears all the risks of one company with none of the hedging benefits of a portfolio. Dumb money is those pinkish guys with bull necks in Zegna suits. The weird thing about dumb money, unfortunately, is that it can act with fiendish intelligence, insisting on stipulations that guarantee returns at the expense of founders, employees and other investors.

Luckily for the American economy, the dumb money this time around is no longer a mob of deluded pensioners waist-deep in Webvan. (It’s also, the V.C.s noted, a lot less money in total, and at least in theory it’s coming from people who can afford the losses; the last dot-com crash erased an estimated $6.2 trillion in household wealth.) So the coming correction will allow the smart money to roll up its brushed-microfiber sleeves and get back to basics. A lot of $10 billion companies will become $1 billion companies, and $1 billion companies will be acquired for $100 million, and the dumb money will slink away. Operating expenses and burn rates will come way down, and companies that didn’t worry about profitability or unit economics will. There will be layoffs, sure, but the only serious effects will be that the traffic on I-280 will no longer back up three exits, it’ll be easier to get a table at the Village Pub and engineers three minutes out of Stanford will no longer expect $150,000 a year and backlit fountains of complimentary fruit water.

Credit Illustration by Andrew Rae

The main thing that has changed since January is that very little seems to have changed. V.C. investment over the first quarter of the year has remained flat, at about $12 billion, from the final quarter of 2015, though a flight to perceived quality has caused both a drop in the total number of deals and a concentration at the top. The total number of tech I.P.O.s, however, was zero. Yet the flood of money to the Valley has not abated: according to The Wall Street Journal, this has been the single biggest fund-raising quarter for venture capital since the (in retrospect) ominous year 2000.

Bill Gurley, a partner in the firm Benchmark Capital, recently published a blog post in which he reminded his colleagues, in a tone of exaggerated mildness, that table stakes in the industry have perhaps become too high. “Loose capital allows the less qualified to participate in each market. This less qualified player brings more reckless execution, which drags even the best entrepreneur onto an especially sloppy playing field.” Despite warnings like these, companies and V.C. firms have continued to court as much of that loose capital as they still can; almost a decade of aggressive growth strategy, by even the most prudent, demands it. With an utterly dead I.P.O. market, and no appetite among the big public tech companies to acquire companies with bad balance sheets, venture capital is less liquid than ever, and thus increasingly represents a closed system — a system where it is no longer so easy to distinguish good money from bad.

Defenders of that system argue that all they really need are the expected half-dozen mega-I.P.O.s (Slack, Palantir, Snapchat, Uber, Airbnb) to make enough cash returns to offset the losses. But that fantasy math holds for only a tiny cohort of V.C. firms. It also overlooks the well-being of tens of thousands of employees, especially support staff, who have worked for years for a share in the wealth they’ve created. Perhaps worst of all, it betrays a callow belief that the genuinely transformative long-term endeavors that V.C.s have come to support — erstwhile academic research into artificial intelligence, bioengineering and sustainable energy — will be somehow insulated from an industry downturn. An exploded bubble could very well mean that those “totally audacious” bets will go unfunded entirely. That might seem like a satisfying comeuppance for the imperious Valley, but it’s not something to be smug about. Smart money convinces itself of its highly differentiated intelligence at what might prove to be all of our expense.

As a founder, you may be tempted to jump the gun on raising money to fund your business, but it’s worth considering a few things first before you go knocking on investors’ doors. For an emerging company, timing truly is everything, and your decision on when and how to raise the money could spell out success or disaster, depending on how you formulate your strategy.

Nine entrepreneurs from Young Entrepreneur Council (YEC) share the variables you must take into account before going out to raise a round of funding for your business.

1. Your valuation.

There are so many different factors that can change the valuation of your company. Try to build up your company value as much as possible before going out to raise funds. Once you feel that you’ve done everything possible to maximize your positioning, then go out and raise.–Ayelet Noff, Blonde 2.0

2. Your goals for the funds.

While considering a raise, be absolutely clear about why you need the money. You should be able to articulate exactly where you are now, where you want to go and how the money will help you get there. Be as detailed as possible with your “use of proceeds” and weave the financial resources into your roadmap and strategy. You must be able to share this same story to investors and substantiate it.–Andrew Thomas, SkyBell Video Doorbell

3. Whether you need to raise funding.

First, ask if you really want to give up some control over the direction and operations of your firm. Bootstrapping LexION Capital was not easy, but the benefits were well worth it. I’d encourage any owner to do the same: if you can self-fund, you don’t face the prospect of limiting your dream to the time frame and strategy your investors want. You retain total ownership of your firm and your vision.–Elle Kaplan, LexION Capital

4. When you’ll need funding.

Assuming that you’ve decided that you need the money, you should spend some time determining how quickly you’ll need it. Venture money (if your company is qualified) takes a long time, and often grant money takes even longer. Bank loans or friends and family investments can take much less time. Obviously there are other considerations, like how much of your company you’re willing to give up, or if you’re willing to take on debt.–Kofi Kankam, Admit.me

5. What you’ll use it for.

By far the most important factor to consider before deciding to raise money for your business is what you’ll use it for. The proper way to evaluate your needs is by creating a use of proceeds, which is an analysis of your cash needs over a specific period of time (typically 24 months) to accomplish your goals. Goals should focus on growth such as hiring, advertising and software development.–Obinna Ekezie, Wakanow.com

6. Timing.

Is it the right time? Often, you only get one chance to impress investors. Ask yourself, “Does the business need money at this time?” You don’t want to try to raise funds until it is necessary for the success of your business. You also need to make sure that you have your business in order, and you have to be prepared for the scrutiny you will face from investors.–Chuck Cohn, Varsity Tutors

7. Product-market fit.

Raise money to scale what you are already doing that is working. If you don’t have product-market fit, do not raise money — you’ll only anger potential investors, so use your own money to figure that out. Work with people you trust, but don’t give more than 10 percent of your company away during this phase. If you do choose to raise money, raise less than $200,000. Without market fit, you’re doomed.–Adam Root, SocialCentiv

8. How much money you need.

With unicorns abounding today, the temptation to raise big money is huge. But over-raising is even worse than under-raising, as you can always raise more, but you can’t “divorce” your existing investors or terms. Make sure you are only raising enough for a well-conceived, thoughtful and detailed strategy.–Afif Khoury, SOCi, Inc

9. Your audience.

If you don’t understand your audience, you won’t be able to build a sustainable business. Before you look into raising money for your business concept, be sure that your product and/or service is really solving the problem that your audience has in an efficient and cost-effective way. You need to be secure in the fact that your audience will buy and love what your business is offering.

With all this talk of unicorns in venture capital, it’s easy to assume that every venture firm’s portfolio is shimmering with billion-dollar companies. But just because they’re breeding like rabbits doesn’t mean unicorns are just as commonplace.

Today, there are more than 80 unicorns, or companies with a valuation of at least $1.0 billion—that’s more than double the number last year, and, according to CB Insights, just three fewer than the last three years combined. As for unicorn exits: 2014 saw almost twice as many billion-dollar exits (32) as 2013 (17).

But it wasn’t too long ago that unicorns were still an urban legend and a relatively rare sighting in the venture world. So why the sudden increase? And who are the VCs lucky enough to ride with them?

Startups in Silicon Valley, the epicenter of the tech world, and the U.S. overall have seen an unprecedented amount of investment as consumers and businesses buy into more online services, and investors flock to fund the next big thing. But the ripples of that trend are being felt elsewhere, too. A new report says that London chalked up a record $682.5 million of investment in the first three months of this year, a rise of 66 percent on a year ago and busting through the previous record of $411.62 million, set in Q4 of last year.

At the current rate, investments in London startups are on track to break past $2 billion this year.

The figures, tracked by London & Partners, the mayor of London’s business development group, also speak to how out of balance the tech economy is in the U.K. That $682.5 million makes up 80 percent of all VC investment in the U.K. for Q1 ($856.7 million).

Venture capital investors are scrambling to tap the wisdom of the crowd, financing projects that found their first legs in crowdfunding.
Crowdfunding platforms have become “a valuable source for dealflow” for venture capital investors.

Venture capital funds raised more money and more funds held closings in the first six months of this year than in any first half in at least six years.

The total raised was $17.35 billion, a 53% increase over the first half of 2013, according to Dow Jones LP Source. Early-stage funds helped increase the number of funds closed, but the bulk of the money went to late-stage and multistage funds.

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If you’re an entrepreneur looking for an investment, or an investor looking to make some money, what should you look for in a VCs? Here are five rank-ordered areas to assess:

1. Relationships. Who does the VC know, invest, work, travel and win with? Look for relationship pedigrees that include major law firms, successful entrepreneurial testimonials and happy institutional investors.

2. Performance. While VCs win whether they succeed or fail, you need to know what the empirical record actually shows, not lore or hearsay, but actual results, like the internal rate of return of each and every fund they’ve raised and the carried interest that investors actually received. Take no prisoners here: this is the most important due diligence you will ever do.

3. Advocacy. Assess the firm’s orientation — is it an entrepreneur-friendly firm or a firm that’s focused primarily on its investors? There are strengths and weaknesses with each bias, but remember that entrepreneur-friendly firms have better deal flow than firms that have investor biases.

4. Knowledge. While many VCs are not rocket scientists, they should also know enough about themselves to know what they don’t know. There is no more deadly combination than arrogance and stupidity — if you see this combination, run for the hills.

5. Professional integrity. It’s important to calibrate the integrity and ethics that define your VC firm. If you’re wondering why “professional integrity” is last on my rank-ordered list, it’s not that professional integrity isn’t important, it’s just that the other four areas are more important. This will tell you everything you really need to know about VCs.